What Is Segregation?
Segregation is the separation of an individual or group of individuals from a larger group, often to apply special treatment to or restrict access of the separated individual or group. Segregation can also involve the separation of items from a larger group, as seen with the handling of funds in certain types of accounts.
Segregation applied to the securities industry, for example, requires that customer assets held by a broker or other financial institution be kept separate—or segregated—from the broker or financial institution's assets. This is referred to as security segregation.
Security segregation became a rule in the late 1960s and was solidified with the advent of the SEC's consumer protection rule, Securities Exchange Act (SEA) Rule 15c3-3. The goal is to keep client assets from commingling with company assets so that if the company goes out of business, the client assets can be promptly returned. It also keeps businesses from using the contents of client accounts for their own purposes. Segregated account management ensures that decisions made are according to the client's risk tolerance, needs, and goals.
SEA Rule 17a-5(a) requires broker-dealers to file monthly reports regarding the proper segregation of customer accounts, as well as reserve account requirements.
Example of Segregation
For example, a brokerage firm that holds custody of its client's assets may also own securities for trading or investment. Each of these types of assets must be maintained separate from the other, with separate bookkeeping. There may also be separate rules for keeping track of the asset values.
There is also a type of account called a separate, or segregated, account. Segregated accounts usually have different privileges and requirements than those held by the general public. Portfolio managers will often create portfolio models which will be applied to the majority of the assets under management.
However, some discretionary accounts may be introduced for investors with requirements for risk aversion, deviating from the behavior of typical individuals. These separate accounts are often allowed to dictate desired deviations from the portfolio managers' usual portfolio holdings.